“…Pour your sugar on me, baby
I’m gonna make your life so sweet, yeah, yeah, yeah…”
Sugar, sugar – a pop song from 1969 by The Archies
Markets continued to grind their way upwards over the course of the week commencing 19 October 2015. The S&P 500 is now back in positive territory year-to-date (see Exhibit 1 below), but that is as nothing to the DAX German Stock Index which as of Friday, 23 October, was up over 10% in local terms over the same period, with 6.83% of that gain coming in the week commencing 19 October alone (see Exhibit 2 below). Bond market reactions have been more muted, but the US 10-year note had negative days for four out of five trading sessions in the week. This has been, in short, a good period for risky assets, and perhaps mediocre at best for more defensive asset classes. That is what the European Central Bank (ECB) will have wanted.
Exhibit 1: Evolution of the Standard & Poor’s 500 index between 2 January 2015 and 30 October 2015 – after a strong month in October, the index is back in positive territory
Source: Bloomberg, as of 30 October 2015
Exhibit 2: Evolution of the DAX German Stock index between 2 January 2015 and 30 October 2015 – a strong month in October
Source: Bloomberg, as of 30 October 2015
Eurozone year-on-year (YoY) inflation is currently -0.1%. The ECB targets 2%. Core is not as weak, but at 0.9% it is not on target (last hit in 2008), despite a huge quantitative easing (QE) programme. The ECB’s forecasts call for 0.1% inflation in 2015. To combat this, the ECB has been purchasing approximately USD 60 billion worth of bonds per month since announcing QE in January, with some adjustments to enhance flexibility. Deposit rates in the eurozone are already negative. While we cannot know the counterfactual, on the face of it the policy does not seem to have been effective.
As a result ECB President Mario Draghi used the press conference following the ECB’s meeting on Thursday 22 October to inform markets that the ECB was ready to increase policy accommodation, with details to be announced at its 3 December meeting. An increase in QE asset purchases, both on a monthly basis and in terms of overall size, as well as a further reduction in the already-negative deposit rate look somewhere between possible and likely.
Yields declined and European curves flattened on the news, but it has been perhaps most pronounced in European peripherals. Exhibit 3 (below) shows the change in the yield curves of Spain and Italy between 23 September and 23 October 2015. What is striking is that both countries are now negatively-yielding out to about two years. While German yields are now negative out to six years, this is still remarkable. Spain has emerged as something of a poster-child for austerity policies, but Italy has not. Italian debt/GDP is now 132%. It breached 120% in 2012, regarded at the time as a possible tipping-point for fundamental unrepayability. The same borrower now requires implicit payment for the privilege of holding its debt.
Exhibit 3: Italian and Spanish yield curve change between 23 September 2015 through 23 October 2015
Source: Bloomberg, as of 23 October 2015
The euro has been on a modest strengthening trend since the Federal Reserve (Fed) declined to increase interest rates at its September meeting and indeed as prospects for an imminent Fed hike seem to have receded. After Draghi’s comments, the US dollar strengthened sharply against the single currency, to close the week at a little over USD 1.10 versus the euro, levels not seen since August.
Besides an outlook that is flirting with disinflation, the macroeconomic picture remained distinctly cloudy. Likely, China will not experience the so-called hard landing – but with data the market does not always find reliable, that cannot be taken for granted. We will get the first estimate of US third-quarter GDP growth this coming week, but the signs are more ambiguous than they have been, though we should not get unduly carried away with negativity. Payrolls was clearly negative, but somewhat surprisingly after negative headlines from the likes of Alcoa, Walmart, Yahoo and much of the financial sector, at time of writing with 173 of the 500 constituents of the S&P having reported, 74.57% have reported positive earnings surprises. Can this continue?
The market’s bet is that it does not matter – or rather, that the upside of weakness is a lot more sugar. As parents of small children know, the sugar crash is often unpleasant – but that’s a problem for later.